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Beware of those who cry 'bubble' about bonds

The nature of bubbles is that very few people recognize them at the time. And, in fact, many of the people who point to a bubble in Treasury bonds — with some notable exceptions — seem to be peddling gold.

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If you were strolling through London in the mid-19th century, the odds were good that someone would grab your hat and shout, "What a shocking bad hat!" This would be followed by general merriment and the loss of your hat. It was an Internet meme before there was an Internet.

The hat craze was recorded by Charles MacKay in Extraordinary Popular Delusions and the Madness of Crowds, first published in 1841. The book describes the silly fads and manias that strike the public and is mainly remembered for its vivid accounts of financial bubbles, especially the mania for tulip bulbs that struck the Dutch in the 1600s.

Thanks to the technology bubble of the 1990s and the housing bubble of the mid-noughties, U.S. investors are a bit too familiar with bubbles: Spotting the next one has become a cottage industry of sorts. But you should be wary of someone who shouts, "Bubble!"

The nature of bubbles is that very few people recognize them at the time. And, in fact, many of the people who point to a bubble in Treasury bonds — with some notable exceptions — seem to be peddling gold.

We understand the word "bubble," in a financial sense, to mean "a stupidly overpriced asset." And that's a decent definition to start with, but bubbles also imply mania — a kind of gleeful, we're-all-going-to-get-rich mentality that grips the population at large. During the technology boom, companies could go public despite not having earnings or even any sales. At the height of the housing boom, people would engage in bidding wars for shacks, and banks thought that taking your pulse was the same as checking your credit.

Robert Shiller, the Yale economist who spotted the housing bubble before it collapsed, says that people often forget the psychological component of bubbles. "I find that the term 'bubble' is not well-defined in dictionaries," Shiller writes in an e-mail. His definition, from his 2000 book, Irrational Exuberance:

"Irrational exuberance is the psychological basis of a speculative bubble. I will define a speculative bubble as a situation in which news of price increases spurs investor enthusiasm which spreads by psychological contagion from person to person, in the process amplifying stories that might justify the price increase and bringing in a larger and larger class of investors, who, despite doubts about the real value of the investment, are drawn to it partly through envy of others' successes and partly through a gambler's excitement."

Have you been tempted to buy a 10-year Treasury note, currently yielding less than 2%, any time in the past three years? Have you heard your neighbors bragging about how they bagged a 30-year T-bond at auction? Do you mark your calendar for Treasury auctions, hoping to scoop up a couple of two-year T-notes at 0.23% yields? Probably not.

"The statement that the bond market is in a bubble doesn't seem to match my definition, for I think that the high prices in the government bond market now are due to a flight to quality more than the kind of investor enthusiasm that marks a bubble," Shiller says. In other words, people buy Treasuries because they are seen as safer than, say, Italian or Japanese bonds, rather than because they think they will get instantly rich.

Edward Chancellor managed to spot both the technology bubble and the housing bubble and is author of Devil Take the Hindmost: A History of Financial Speculation. He's not convinced there's a Treasury bubble, either. "People use the term 'bubble' without thinking about what it means," Chancellor says. "When one is making a comment about a bubble, you're saying that the asset will come down in valuation, with a very high degree of confidence and by a great deal. The question, then, is how stable is the valuation."

In stocks and real estate, we have very long data sets for how stable both assets tend to be. You can look at long-term average gains and measure whether stocks, for example, are much higher than their average, and expect that sooner or later they will come back to that average.

Bonds, too, have a nice long data set, but they are much more stable: The cycle of ups and downs tends to be much longer than those of stocks or real estate, Chancellor says. "Peaks and troughs in the bond market come in roughly 40- to 50-year periods, and it's tough to call the turn in that. You could have called the Treasury bond market overpriced 10 years ago, and you would have been wrong."

None of which is to say that Treasuries at current yields are a particularly good investment. They're just not bubbles, as defined by people who actually have a proven track record of spotting bubbles. Chancellor thinks that Chinese real estate could be in bubble territory: The value of Hong Kong housing stock to GDP is higher now than it was in 1998, when it was widely viewed as a bubble.

Those who are predicting a bursting Treasury bubble — which would mean soaring yields, plunging bond prices and a currency collapse — point to gold as a real store of value. Except, of course, it isn't, as anyone who bought at its peak of around $1,900 an ounce could tell you. When gold really was a bubble in 1981 and people were burying Krugerrands in their backyard, gold averaged $613 an ounce, according to gold dealer Kitco. Adjusted for inflation, that's $1,727. Is it really so surprising that gold is down to $1,570 now?